In an interview with IndexUniverse ETF Analysts Dennis Hudachk and Howard Lee, KraneShares Managing Director Brendan Ahern spoke about why the firm’s funds are different from the current suite of available China ETFs. Ahern also discussed China’s latest Five-Year Plan, and how the new regime in China is serious about implementing changes to pursue a more sustainable growth model for the long term. Despite the recent rout in emerging markets, he sees opportunities in China.

IU: Tell us a bit about China’s Five-Year plan, and what KFYP attempts to do.

Ahern: It’s the goals for the country for the next five years and a top-down-driven government plan. It’s social, it’s cultural, but it’s becoming more around the economy, and where the Chinese government wants to push its economic goals. The latest five-year plan, which is the 12 th five-year plan, focuses on seven strategic or focused industries.

Traditional benchmarks are very heavily weighted to two sectors, predominantly financials and energy. In some cases, financials represent over 50 percent of the sector weighting of ETFs. We don’t believe that half of the 1.3 billion people in China work in finance. Working with CSI—China Securities Index Company—the largest index provider in mainland China, we wanted to look for a way to capture where China is going.

Certainly, we wanted to do this in a passive format. We’re not active managers, and we’re certainly not fundamental investors or fundamental indexers. So we wanted to capture these seven focus industries, where the Chinese government is literally investing hundreds of billions of dollars in its attempt to reorient the economy away from a fixed investment to more of a domestic consumption-driven economy.

IU: Could you give us more insight into what those seven strategic industries are?

Ahern: The seven are energy conservation and environmental protection, new-generation information technology, the biological industry, high-end equipment manufacturing, the new energy industry, the new material industry, the new energy automobile industry, and then within the broader context is the theme of urbanization and domestic consumption.

As of last year, there were more urban dwellers in China than rural dwellers. The New York Times, just about a month ago, ran a front-page article on the Chinese government’s goal of moving another 250 million of its population from rural, agricultural-driven areas into urban centers.

The Chinese government is trying to move up-market, moving its industries from the FoxConns, which is really a low-cost manufacturer, into more of a Siemens-like model, which is more high-grade manufacturing. You don’t turn the world’s second-largest economy on a dime, but you feel that owning these underlying sectors and subsectors represented in the five-year plan is a highly differentiated approach.

We believe the new regime that came into leadership in March is really adhering to this reform-minded agenda, and investors need to be aware that there’s been a change in China that I think a lot of the headlines out there don’t really capture.

IU: What about agriculture? Is KFYP indirectly exposed to that sector at all?

Ahern: Certainly the mechanization of agriculture plays a part as well. In general, food safety is a very important trend in China. You see that most recently with the Smithfield deal here in the U.S., where Chinese companies can be buying the largest pork producers here in the U.S. Part of that is because the U.S. has an institutional food structure in place. And conversely, in China, it’s really small, family-owned farms.

Ahern (cont'd.): So there’s a movement to raise food safety. Some of that’s driven by the growth of the middle class. One name within our portfolio is Sinofert, which is really a fertilizer company. Some of this is captured from the industrial perspective, as Chinese companies create their own versions of Caterpillar and John Deere. But food safety is a very key issue, particularly for the burgeoning middle class.

IU: KFYP has a unique selection scheme that’s different from market-cap selection schemes of other broad-based China ETFs. How does KFYP selects its constituents?

Ahern: CSI has an index committee. CSI really created this index by looking at both a sector and subsector of the investable universe. Certainly we wanted to give them some input on creating an index that works in a U.S. ’40 Act structure, something that works for U.S.-listed exchange-traded funds. We really wanted to leverage the Chinese perspective on how to make this investable.

One of the things we really liked about CSI is they divide Chinese equities into two components. You have mainland securities, which are listed on the Shanghai and Shenzhen Stock Exchange, which, for the most part, are uninvestable to foreign investors as of today.

And secondarily, they consider Chinese companies that are listed in Hong Kong or on the Nasdaq or New York Stock Exchange, or Singapore as overseas. Part of the confusion around investing in China is that you have a multitude of different share classes.

So we like their holistic approach of viewing Chinese securities in a very simplistic and concise manner. The idea was to really capture that universe that’s investable to foreigners today. So the vast majority of our securities are listed on the Hong Kong exchange, the NYSE or Nasdaq.

IU: Would you consider KFYP to be a core holding, to replace the FXIs and the GXCs? Or is KFYP meant more as a complement to these types of broad-based China funds?

Ahern: I think it could be both. The legacy ETFs have very concentrated holdings from a sector perspective. We have no exposure to financials, energy or the traditional telecom players. So it can be a complement. I don’t think our story is one of cannibalization.

I think, secondarily, there’s something very intuitive about this approach about following the Chinese government telling you where they’re going to be investing, literally, hundreds of billions of dollars, and owning those underlying securities. So I think KFYP can also be very much a stand-alone approach.

I think that the secondary approach is very important in understanding this new regime that’s in power, and what its goals are. They’re not paying lip service to reform. They’re really implementing it.

Again, that’s something that won’t happen overnight. It won’t happen over the course of a quarter or a few years. This is probably a multidecade goal on their part, and we think we’re very well positioned, because from a sector perspective, there are going to be winners and losers. We have a very strong approach for the new policies that are being implemented by the government.

IU: How flexible is the index methodology in adapting to new political goals, or targets set by the regime? Let’s say they changed their mind; how flexible is their methodology?

Ahern: CSI’s view is that the five-year plan is fairly static. If not, it wouldn’t be the five-year plan. Part of that is just the effort that goes into creating the five-year plan, which is a yearlong process that involves all aspects of the government. It’s really about aligning all the different government agencies involved in the economy with one goal. We think that’s very beneficial, because it allows us to create a portfolio and then not be making adjustments.

Ahern (cont'd.): If your definition of China is really defined by two sectors (financials and energy), those have been two of the weaker performers. Our contacts in the mainland are telling us that those two sectors might continue to struggle. So we think we’ve got a great differentiated approach for a reform-minded leadership that is really trying to implement more stable growth, economic growth for the years to come.

IU: I want to talk a little bit about KWEB, your China Internet fund. With several ETFs in registration, why did KraneShares decide to go with China Internet?

Ahern: One of the things that really jumped out to us was the adoption and acceptance of the Internet as an e-commerce or e-retailing outlet. Increasingly, retailing is taking place online and, regarding the big-box stores that we’re used to here in the U.S. that have really been hurt by technology and companies like Amazon or Priceline, China is jumping over that stage in a lot of respects.

We’re working with a dedicated China Internet research company called iResearch. We’re looking forward to putting out to investors a lot of the research to help them understand that these technology companies are, in many respects, e-retailing companies.

The industry as a whole, according to McKinsey & Co., has grown at a clip of 120 percent each of the last 10 years. Mobile Internet use is up to 480 million people in China, and penetration is still growing. So there’s the potential for these companies to continue these vast rates of growth.

There’s also a company called Alibaba, which will be going public later on this year. It’s apt to be the largest IPO globally this year. The whole world is going to know the China Internet story, because Alibaba is just going to be too big to ignore. So we like the idea of getting a product out there in advance of Alibaba’s IPO.

IU: There’s a tremendous amount of pessimism right now in China, and emerging markets in general have been hammered on speculation of imminent QE-tapering by the Fed. Why launch a China fund now?

Ahern: China has the world’s largest population. It represents almost 20 percent of the world’s population. It’s the world’s second-largest economy, at about 11 ½ percent of global GDP. And yet China’s investable non-mainland markets represent only 2 percent of the global equity market capitalization.

There is a differing view from a lot of people on the mainland about the opportunities that are taking place there, and we wanted to plant the flag as the China thought leader. We’re going to be taking a lot of research from partners on the mainland and making that available to U.S. investors, to provide that contrarian view to China.

I think, secondarily, it’s this political change that’s taking place. It’s really one of the most under-reported stories that I can think of, where you have a leadership that is very, very dedicated to reforming its economy. The days of double-digit GDP growth probably are behind us, but what’s going to be coming forward is certainly apt to be more stable, more moderate growth. And certainly, 7 percent GDP growth looks very appealing versus, say, the growth the G-8 world is experiencing.

Certainly a lot of what we want to report is what our partners from the mainland are telling us. We just want to be kind of the conduit of that information. What lies ahead won’t be that credit-driven stimulus that we’ve seen historically. What should come out of this, going forward, should hopefully be robust growth by the standards of the U.S. and Europe, and hopefully more stable. We think we’ve got a good way to play that transition.